Economics for Managers

by McGuigan, Moyer, & Harris

PowerPoint Lecture Slides

prepared by
Richard D. Marcus
University of Wisconsin - Milwaukee

2008 Thomson * South-Western Slide 1

 Chapter 1
Introduction & Goals of the Firm
» Introduction
» Structure of Decision Models
» Profit’s Role
» Agency Problems & Solutions
» Not-for-Profit Organizations
» Why Corporations Have Succeeded
Over Other Organizational Forms
Slide 2
What is Managerial Economics?
Integrates and applies microeconomic theory and
methods to decision making problems faced by
private, public, and not-for-profit organizations.

Managerial economics deals with microeconomic

reasoning on real world problems such as pricing
decisions, selecting the best strategy in different
competitive environments, and making efficient
choices.

Slide 3
 To Expand Capacity or Not?
• Should Toyota expand its capacity? In part, it must
consider current and future demand and what other
firms are likely to do.
• Capacity for making cars is a long term project, so
Toyota should think in terms of the present value (PV)
of future profits.
• Objective Function:
» Max PV of profits {S1, S2}
» S1 could be expand capacity and S2 not to expand yet
capacity at this time.
• Decision Rule:
» Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
» Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
» If equal profits, then flip a coin
Slide 4
 The Decision-Making Process
(Figure 1.2)

1. Establish Objectives
2. Identify the Problem
3. Examine Alternative Solutions
Consider 4. Analyze Alternatives Consider
Organizational
Societal and Select the Best! & Input
Constraints Constraints

5.Perform Sensitivity Analysis

6. Implement and
Monitor the Decision Slide 5
 The Role of Profits
• Economic Profit is the difference between
revenues and total economic cost (including
the economic or opportunity cost of owner
supplied resources such as time and capital).
• We’d expect high profit areas to attract
investment
• We’d expect low profit areas to lose
investment
» Shouldn’t then all industries
earn the same profit eventually?
Slide 6
 Theories of Why Profit Varies
Across Industries
1. RISK-BEARING THEORY
2. TEMPORARY DISQUILIBRIUM
THEORY OF PROFIT
3. MONOPOLY THEORY OF PROFIT
4. INNOVATION THEORY OF PROFIT
5. MANAGERIAL EFFICIENCY THEORY
OF PROFIT

Slide 7
What Went Right?
What Went Wrong?
• Eli Lilly (p. 16) a Pharmaceutical company
» 12.3 on average to get a new drug approved
» Patents on Lilly’s Prozac created monopoly power and profits for a
widely used medication for depression.
» As the patent began to expire, Lilly requested s patent “extension”
because of some alterations in Prozac’s formula
» But when the patent extension was overturned, generic drug
manufactures took 70% of the share of the market for anti-depressants.
» Lilly missed the chance of finding a replacement in time for its
blockbuster Prozac

Slide 8
 Objectives of the Firm
• Profit maximization
• Shareholder wealth = value of each share (V0)
times the number of shares outstanding, or
V0 · (# shares outstanding). This is the present
value of expected future profits or cash flows,
discounted at the shareholders required rate of
return, ke, ignoring taxes. 
V0 (shares
t=1
outstanding) =   t /(1+ke)
t

Slide 9
 Determinants of Firm Value
(Figure 1.3)
t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft

• Value of the Firm = the present value of discounted cash flows

N
(t ) / (1+ke)t =
t=1

N
(PtQt – VtQt – Ft) / (1+ke)t
t =1

• Whatever lowers the perceived risk of the firm (ke) will also raise firm value.
• Whatever raises the price of the product (Pt) or the quantity sold (Qt ) will
raise firm value.
• Whatever raises variable cost (Vt )or fixed cost ( Ft ) will reduce firm value.

Slide 10
• To make good economic decisions, managers
need to be able to forecast & estimate relationships
• Will be forecasting demand (both Pt & Qt)
» applies to for-profit corporations
» non-profit organizations
• Hospital Administrators forecast patients
• University Administrator forecast enrollment

• Regression analysis, time series methods, and

qualitative forecasting methods used for
forecasting

Slide 11
 Agency Problems
• Modern corporations allow firm
managers to have no ownership
participation, or only limited
participation in the profitability of the
firm.
• Shareholders may want profits, but
managers may wish to relax.
• The shareholders are principals, whereas
the managers are agents.
Slide 12
• The Principal-Agent Problem
» Shareholders (principals) want profit
» Managers (agents) want leisure & security
» Conflicting motivations between these groups are called
agency problems.
• Examples (page 13)
» KKR’s takeover of RJR Nabisco to refocus on wealth-
maximization
» The LBO by O.M. Scott (a lawn fertilizer company)
from ITT (a conglomerate) improved Scott’s
performance

Slide 13
Solutions to Agency Problems
• Compensation as incentive
• Extending to all workers stock options,
bonuses, and grants of stock
» It helps to make workers act more like owners of
firm
• Incentives to help the company, because that
improves the value of stock options and
bonuses.

Slide 14
 What Went Right? What Went Wrong?
• Saturn Corporation (p. 15)
» Different kind of car company in 1991
» No-haggle pricing
» Sales were above expectations
• But, margin of only $400 per car to GM
» GM earned only 3% on capital
» Saturn customers wanted bigger Saturns rather than trade up to Buick, as
GM hoped.
» When the dollar appreciated, Japanese firms could price their cars more
competitively.
» Must continuously keep up with global competitors.

Slide 15
 Shareholder Wealth Maximization:
Necessary Conditions
• COMPLETE MARKETS - liquid markets for
firm's inputs and by-products (including polluting by-
products).
• NO SIGNIFICANT ASYMMETRIC
INFORMATION - buyers and sellers all know the
same things.
• KNOWN RECONTRACTING COSTS future
input costs are part of the present value of expected cash
flows.

Slide 16
 Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
 Public Goods are goods that can be consumed or used by more than one
person at the same time with no extra cost (like a flood control or
national defense).
 Sometimes governments produce public goods. Other times, they are
exclusive to one person (like a free meal).
 Instead of profit, NFP organizations may have as their goals:
1. Maximization of the quantity of output, subject to a breakeven
constraint.
2. Maximization of the utility (happiness) of NFP administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP organization.

Slide 17
• Which goal a NFP manager selects affects decisions
made.
» A food shelter manager may decide to maximize the
utility of contributors by selecting only "healthy foods"
• Public sector managers are performance monitored .
» V.A. hospital administrators are rewarded by reducing the cost
per bed over a year. Hence, they become efficient with respect to
costs.
» The "friendliness" of the hospital staff is harder to measure, so
friendliness will tend not be a high priority of the public sector
manager.

Slide 18